Funding Asian infrastructure: The ancillary factors

When a road is not a road

Whatever the macro-market conditions, it's helpful to remember that "...a road is not a road is not a road," as Campbell Lutyens partner John Campbell puts it. In other words, every project is very much individual, and because of this can be financially structured in any number of ways.

One possibility, for example, may be downside protection in exchange for relinquishing some of the upside. This ensures that even if few cars ever go through the new tunnel the investor still realizes something to the tune of 6% for 35 years. If the traffic flow projections are borne out, and the tunnel produces upwards of 12-14%, the investor is obligated to share more with the other partner(s) - in many cases, a government agency.

A different investor with a different focus may opt to ignore such a hedge, instead looking to realize an additional 2% on the top end in exchange for bearing the risk of losing out if the forecasted traffic doesn't materialize.

Still other options may include writing a mezzanine instrument, as opposed to a pure equity instrument, Campbell notes, or perhaps forging a combination of the two.

Specialization

Another aspect to consider is the specialization element. This encompasses both specialist investors, and the available number of relevant, specialist professionals on the ground in Asia.

"If you're dealing in unlisted opportunities, and growth opportunities, infrastructure encompasses pretty specialized areas," explains JPMorgan infrastructure team leader Philip Jackson. "That's why our view is that you need to have specialist investors who understand the regulatory frameworks that relate to the underlying investments. The same is true of complex project management construction issues and financing issues."

As well, he points out, given the expert skills that are needed to make infrastructure investments successful, the number of people on tap in the region with the expertise and extensive experience is somewhat limited. But he's confident that the pool will deepen in time.

Nevertheless, with the characteristic longer duration of infrastructure funds, it is reasonable to ask whether this amounts to a limitation in attracting and retaining such people. And here opinions were mixed.

Rob Petty, Clearwater Capital's co-founding partner, told AVCJ, "Longer duration funds mean longer duration carry, and that means it's harder to think about how people get paid."

JPMorgan's Jackson takes another view. "I'd say the carry program for a ten-year infrastructure fund is likely to be very similar to an equivalent ten-year private equity fund. So the short answer is no."

The impact of Basel II

Another more distant yet still significant factor is the effect the recent Basel II regime may ultimately have on the sector.

EC Harris, a leading international built assets consultancy and their Singapore-based spokesperson, Richard Marriott, identified some of the possibilities in a recent study. They concluded (from a global perspective) that the implementation of Basel II could create both issues and opportunities for all parties in the project finance sectors, including lenders, project sponsors and infrastructure investment funds.

Most notably, they say, "...Basel II allows banks to use their experience and sophistication of credit risk management as a source of competitive advantage."

The 8% minimum overall capital adequacy requirement is supplemented by specific criteria for each asset class. This allows a bank's capital reserves to reflect its individual risk exposures more closely than was previously the case. Whether this adds to or reduces individual loan costs will depend on a number of things, including the sophistication of the lending bank and the nature of the project.

From a project sponsor's standpoint, packaging a project effectively to attract the best credit rating will result in the lowest debt cost. Thus by improving credit risk structuring, presentation and management, sponsors will reap an improvement in bankability and lower project financing costs.

As for infrastructure investors, banks will need to make much higher capital provisions against lower rated or deteriorating loans. A new market may open up for infrastructure funds to buy out under or non-performing loan positions at a discount, paving the way for access to solid assets at a good price.

JPMorgan's Philip Jackson adds that in general Basel II will have an impact on the banks' ability to lend, and indeed their risk appetite worldwide. But as a counterbalance in Asia, he further notes that the regional banking community is much better positioned than their European or US counterparts.

"They learned some painful lessons about liquidity and the short-term financing of long-term liabilities in the Asian currency crisis of the late 1990s. Thus they were much more cautiously run going into the recent GFC."

Seen from another angle, however, Basel II is likely to make banks more conservative. But that may prove a boon to infrastructure investment.

"If you are a bank in uncertain times, you are tightly focused on the quality of your loan book and the predictability of cash flow in the companies you've invested in. And in that context, infrastructure is reliable," says Jackson. "If you think of the New Jersey Turnpike, for example, whether you have boom times or recession, people will still drive to work. And that, at base bottom, is why the sector will continue to be attractive to banks to lend to. Nobody's worried that Basel II will cause infrastructure deals that otherwise would happen to be aborted."

Governments and infrastructure investors

More pointedly important is awareness of the need for a close relationship among private infrastructure interests, governments and the public sector. This is the vital public-private-partnership (PPP) matrix, which John Campbell sees as "...the sine qua non that will be the essential development factor in any part of the world, because the public sector can no longer finance these projects alone."

Launched in the UK, it has been rolled out in Australia, Canada and more recently the US (where the expectation is that it will grow to enormous proportions in the decades to come).

Another driver Philip Jackson points to is the notion that making a bet on infrastructure is making a bet on the most dynamic part of most Asian economies of the future.

"For those investors who want exposure to Asia, they can get it in the export-orientated industries, which is historically where most of the foreign-invested capital has been focused; or they can get it investing in those sectors which are about the development of Asia's emergent domestic middle class in the heartlands."

"What makes Asia different now - because the region has had a rising need for infrastructure for the past 40 years - is that the middle classes who can afford to pay for services we in the West take for granted, and are frustrated by their absence, now exist," he explains. "And there is little doubt that these countries will continue to industrialize and urbanize."

The regulatory factor

Given the necessarily close interface between infrastructure and governments, whether central, provincial or municipal, however, the reliability of regulatory regimes is key.

Back in the 1990s, when regional governments generally were trying - and failing - to answer the infrastructure imperative solo, they were also consulting with experts like Jackson in developing these frameworks, whether for water supply and quality facilities, the power sector, toll roads, port authorities or the aviation industry. And, not surprisingly, they drew heavily on the experience of Europe and the US.

At the same time, there were a significant number of newly-privatized utilities, power and water companies from Europe in particular who, with their new-found freedom, wanted to expand overseas, he recalls. They brought their expertise with them, but found when they arrived that only rudimentary regulatory regimes-in-the-making were in place. Shortly after, they decamped, further retarding infrastructure development in the region until only recently.

So today, while things have much improved, "...regulation is always a focus for tension before deciding even to look at a sector, let alone a specific opportunity within it," Jackson told AVCJ.

Classically, the role of the regulator is to look after the public interest, anywhere in the world. But in Asia, regulatory agencies have also been tasked with playing a pivotal role in creating the legal frameworks needed to attract the capital to get infrastructure built.

"And that means that the regulatory frameworks [in Asia] increasingly provide a longer-term level of predictability than is more and more the case in the West," he concludes.

John Campbell likewise notes that while the conventional wisdom, from a global infrastructure investment point of view, is that growth market returns should include an additional risk premium, "...you might, in fact, argue it the other way round: that in these markets you've got the wind at your back, so there should be lower rates of return for that, because it's actually a safer bet to have a port, for instance, in a growing part of India or China or Brazil than having one in declining Western Europe or North America."

 

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• Topics
• Infrastructure
• Robert Petty
• Clearwater Capital Partners